Taking an early 401(k) withdrawal might be tempting in certain circumstances, like if you're temporarily out of work or if you're looking to make a large purchase in the near future. Depending on the degree of the emergency, a 401(k) withdrawal might be a valid last-resort option. However, if there are ways to avoid taking money out of your 401(k) early, you'd be smart to explore those paths.
Let's discuss three reasons you might want to think twice about hitting "submit" on a 401(k) withdrawal request.
1. You'll typically be liable for income taxes and a penalty
If you take money out of your pre-tax 401(k) before age 59 1/2, you'll be hit not only with ordinary income taxes, but with an additional 10% penalty on the total amount withdrawn in most situations. That means that you may only receive $0.60 or $0.70 on the dollar after taxes. Depending on how much money you withdraw, the taxes alone can run into the tens of thousands of dollars. Needless to say, an early 401(k) withdrawal is a costly choice in more ways than one.
There are a few scenarios in which the IRS may offer penalty exceptions. They generally fall into the category of "hardship withdrawal," and usually involve serious circumstances like prohibitively expensive medical bills or the onset of a permanent disability. Even in these cases, you'll still be liable for income taxes on any amounts withdrawn from your retirement plan.
Finally, keep in mind that ordinary income tax rates are typically far higher than long-term capital gains rates, and you'll be subject to ordinary income tax on the gross amount of your withdrawal. Depending on where you live, your other income, and your age, your total federal, state, and local tax liabilities could add up to 50% of your withdrawal amount. This is critical to note if you're on the fence.
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2. You'll lose valuable tax-deferred investing capacity
401(k) plans provide useful tax-advantaged investing capacity that regular taxable brokerage accounts don't. In other words, as you accumulate money in your 401(k), you won't pay taxes on dividends or capital gains along the way; you'll only be taxed when you take money out of the plan. By taking money out of your 401(k), you also lose out on the opportunity to see faster growth and to reap the benefits of compound earnings and compound interest.
For example, say you're fortunate enough to have saved $100,000 in your 401(k) by age 35. If you want to take out $40,000 to help fund a home purchase, you'll be left with only $60,000 in the plan. After 30 years of compounding at 8%, and assuming no further contributions, you'll have left nearly $400,000 on the table as a consequence of your early 401(k) withdrawal.
This is no small sum by any measure, so you'll need to be very sure about what you plan to do with your after-tax proceeds before taking money out.
3. You may be ignoring other options
While not a perfect option, taking a 401(k) loan is a better choice than a withdrawal for most plan participants. Most plans allow participants to borrow up to the lesser of 50% of your account balance or $50,000, which makes the loan option appealing to help with most large purchases. The upside here, relative to taking an outright withdrawal, is that you're also signing up to pay the money back with interest. This helps you slowly build back your 401(k) plan balance without the unpleasant tax or penalty bites.
If you don't want to take money out of your 401(k) plan, you do have the option of taking a personal loan at relatively low interest from an online lender or other institution of your choice. You'll still be on the hook for principal and interest, but you'll leave your 401(k) plan untouched. If you own your home, you might also consider tapping your home equity line of credit, but you'll need to be meticulous about making on-time payments to your mortgage lender.
Retirement plans are meant for retirement
The reality is that your 401(k) plan holds money meant to be used in retirement, and you'll need to be prepared to pay a significant amount to access it early. Between taxes, penalties, and the opportunity cost of lost tax-deferred growth, the costs of an early 401(k) withdrawal may be too much to bear.
Regardless of your ultimate choice, make sure you've taken the time to sit down with your 401(k) summary plan document and make a decision that aligns with your personal financial circumstances.
